Foreign Exchange Spot

Use: The Spot Contract is the most basic foreign exchange product. Microfinance clients use this product to buy and sell a foreign currency at the current market exchange rate. This product is used for immediate exchange of funds.

Structure: A spot contract is a binding obligation to buy or sell a certain amount of foreign currency at a price which is the the "spot exchange rate" or the current exchange rate for settlement in two business days time. The trade date is the day on which a spot contract is executed. The settlement date is the day on which funds are physically exchanged as per market convention for "spot delivery" (this is the day when the funds will show in the receiver's account).

Spot Trade

The difference between the trade date and the settlement date in a spot transaction reflects both the need to arrange the transfer of funds and, the time difference between currency centers involved.

Pricing: Pricing of foreign exchange or the spot exchange rate is determined by the demand and supply of the currency in the market.

The demand and supply of a currency can be affected by a country's current rate of inflation and expected future inflation rates, the country's balance of payments, the monetary and fiscal policies of the country's government, various economic indicators which create expectations about the country's economic health, differences between foreign and domestic interest rates and central bank interventions.

A foreign exchange rate quotation consists of two currencies: the 'base' (fixed) currency and the 'term' (variable) currency. A quotation shows how many units of the terms currency will equal 1 unit of the base currency. Banks quote the base currency mostly in terms of the Euro, the Pound Sterling or the U.S. Dollar.

See below the quoting convention for the U.S. Dollar versus the Ethopian Birr (ETB).

According to the exchange rate quoted above, it takes ETB 9.8600 to buy USD 1.00 and USD 0.1014 (1 ÷ 9.8600) to buy ETB 1.00.

Constraint: Spot exchange rate movements are highly unpredictable, even during a single trading day. Relying on the spot market for future foreign exchange can be risky as it exposes cash flows to the risk of unfavorable changes in foreign currency values.

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Forwards & Swaps

Forwards

Use: Forward exchange contracts are used by market participants to lock in an exchange rate on a specific date.

An Outright Forward is a binding obligation for a physical exchange of funds at a future date at an agreed on rate. There is no payment upfront. Non-Deliverable forwards (NDF) are similar but allow hedging of currencies where government regulations restrict foreign access to local currency or the parties want to compensate for risk without a physical exchange of funds. NDFs settle against a fixing rate at maturity, with the net amount in USD, or another fully convertible currency, either paid or received.

Since each forward contract carries a specific delivery or fixing date, forwards are more suited to hedging the foreign exchange risk on a bullet principal repayment as opposed to a stream of interest and principal payments. The latter is more often covered with a cross currency swap. In practice, however, forwards are sometimes favored as a more affordable, albeit less effective, hedging mechanism than swaps when used to hedge the foreign exchange risk of the principal of a loan, while leaving interest payments uncovered.

Structure: An outright forward locks in an exchange rate or the forward rate for an exchange of specified funds at a future value (delivery) date.

Outright Forward Contract

In an NDF a principal amount, forward exchange rate, fixing date and forward date, are all agreed on the trade date and form the basis for the net settlement that is made at maturity in a fully convertible currency.

At maturity of the NDF, in order to calculate the net settlement, the forward exchange rate agreed at execution is set against the prevailing market 'spot exchange rate' on the fixing date which is two days before the value (delivery) date of the NDF. The reference for the spot exchange rate i.e. the fixing basis varies from currency to currency and can be the Reuters or Bloomberg pages.

Non-Deliverable Forward Contract

On the fixing date, the difference between the forward rate and the prevailing spot rate are subtracted resulting in the net amount which has to be paid by one party to the other as settlement of the NDF on the value (delivery) date.

Pricing: The "forward rate" or the price of an outright forward contract is based on the spot rate at the time the deal is booked, with an adjustment for "forward points" which represents the interest rate differential between the two currencies concerned.

Using the example of the U.S. Dollar and the Ethiopian Birr with a spot exchange rate of USD-ETB=9.8600 and one-year interest rates of 3.23% and 6.50% respectively for the U.S. and Ethiopia, we can calculate the one year forward rate as follows:

Forward Rate: (Multiplying Spot Rate with the Interest Rate Differential):

The forward points reflect interest rate differentials between two currencies. They can be positive or negative depending on which currency has the lower or higher interest rate. In effect, the higher yielding currency will be discounted going forward and vice versa.

In an NDF, the forward rate used follows the same methodology as the outright forward, but the actual funds exchanged on the value date at maturity will depend on the prevailing spot exchange rate.

If the prevailing spot rate is worse than the forward rate, the NDF is an asset and the holder of the NDF will be receiving funds from the counterparty as settlement. The opposite holds true if the NDF contract is a liability because prevailing spot rates are better that the original forward rate agreed at inception.

In the two cases above, the USD difference represents the gain or liability on the transaction. The receipt or payment in USD via the NDF is offset by the loss or gain in USD-ETB move.

Constraints: If the underlying reason for wishing to set the exchange rate for a future delivery date no longer exists, the forward exchange contract may need to be cancelled at prevailing market rates. The unwinding of the position may incur a profit or a loss. ( i.e. the 'mark to market' value of the contract). Currency markets are highly volatile and the prices of the underlying currencies can fluctuate rapidly and over wide ranges and may reflect unforeseen events or changes in conditions

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Cross Currency Swaps

Use: A Currency Swap is the best way to fully hedge a loan transaction as the terms can be structured to exactly mirror the underlying loan. It is also flexible in that it can be structured to fully hedge a fixed rate loan with a combined currency and interest rate hedge via a fixed-floating cross currency swap.

In a non-deliverable swap (NDS) there is no physical exchange of the two currency flows. Instead, the USD equivalent of the local currency payment (determined at the spot rate on the date of the payment) will be set against the opposite USD payment, with the net paid to the appropriate party. NDSs are used to avoid transfer risk and to avoid the cost of local market exchange. MFX will contract primarily on an NDS basis.

There are three components in a Cross Currency Swap and the mechanics are as follows: (Opposite USD cash flows will be settled on a net basis.)

For an MIV lending in local currency:

• Initial exchange: The MIV makes the initial loan in local currency or in dollars which the MIV immediately exchanges for local currency.
• Periodic Exchanges: The MIV receives local currency repayments (or the USD equivalent) on its local currency loan and pays them to MFX while retaining its profit spread. In exchange it receives a dollar payment at the agreed LIBOR rate.
• Final Exchange: The MIV receives the principal repayment in local currency (or USD equivalent) and pays it to MFX. MFX pays the MIV the dollar amount calculated at the initial exchange rate for the start of the contract.

For an MFI hedging hard currency exposure:

• Initial Exchange: The MFI exchanges the principal of the loan in hard currency for a local currency principal amount with MFX. The exchange of principal is done at market rates i.e. the spot rate as of the effective date of the swap.
• Periodic Exchanges: Over the life of the loan, the MFI makes interest payments on the local currency principal amount to MFX, and in exchange receives the interest amounts due on the hard currency loan.
• Final Exchange: At maturity, the MFI repays the principal amount in local currency to MFX and in turn receives the hard currency principal amount owed to its lender at the same exchange rate that is used for the principal at the inception of the swap.

Pricing: For a floating-floating currency swap where only the exchange rate is hedged, a market exchange rate (typically, the spot rate as of the effective date of the swap) is used to convert the payment amounts of the local currency into the target currency. The same exchange rate is used for the final principal exchange in the swap.

Interest rate swap terms (fixed for floating) are set so market participants are indifferent between paying (receiving) this fixed rate over time or paying (receiving) a rate that can fluctuate over time. Therefore at origination, the value of the swap equals zero and the present value of the two (expected) cash flow streams equal each other.

The following formula calculates a theoretical rate (known as the "Swap Rate") for the fixed component of the swap contract.

Measuring the current market value of an interest rate swap can be complicated as it involves determining a discount rate, a yield curve and a swap rate. Market variables that affect swap pricing include changes in the level of interest rates, changes in swap spreads, changes in the shape of the interest rate yield curve, and exchange rates. MFX will use standard valuation models for valuing interest rate swaps that match the valuations on its matching swap contracts with TCX and bank counterparties.

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